Impact of Financial Crisis on Bank in Bahrain Finance Essay

The main purpose of the study is to understand the problems faced by bank in Bahrain as a result of the financial crisis. After a lasting time of instability, the global economy finally started to stabilize in 2009 with the assistance of a considerable amount of intervention from the public which resulted in a mount in output and financial market bounce back amidst superior levels of confidence and certainty. All through 2009, world output decreased by 0.6% and was predicted to pick up during 2010 to 2.3% and developing economies by 6.3%.

With inflation issues controlled and commodity prices rebounding from the previous low levels, the globe recovery was expected to continue in 2010, even though at varying speeds around regions. During 2009, inflation for highly developed economies recorded a minor 0.1% growth, in spite of slack monetary policy and near zero interest rates. Consumer prices in emerging and developing markets had an inflation of 5.2% during the same year (2009).

Background of the study:

The impacts of the financial crisis on the Bahraini economy were more visible in 2009. The GDP recorded negative growth. Moreover, real GDP growth decreased to half the rate attained in 2008. On the other hand, in real terms, GDP sustained to rise during 2009, even though at half the speed compared with 2008. Real GDP recorded a growth rate of 3.1% back in 2009, down all the way from 6.3% in 2008. Regardless of the slowdown in the financial sector, it remains one of the largest single contributors to GDP. By the end of the year 2009, the financial sector accounted for 25.1% of real GDP, down from 26.6% in 2008.

As a result of the intervention procedures taken by the authorities to sustain growth, the overall fiscal balance of the GCC countries reduced rapidly during 2009 to achieve an estimated 5.3% of GDP.

barrel in 2010.Statement of the problem:

The motto of the study is to understand the impact of global financial crisis on Bahrain banks. This can be understood from the answer to three key questions:

What impact did the bank face due to the crisis?

How is it affected their investor base?

What are the steps taken to ensure stability during such crisis?

Definition of the problem:

Global crisis began in the late 2008 owing to drastic rise in the defaulter numbers to housing loans in US. This shattered economies everywhere as investors in housing and real sector found their land values depreciating due to the depreciation of dollar. In order to clear debts, many companies were granted aid which finally resulted in banks requiring bailout from the crisis. On the contrary very few economies survived the crisis with proper hedging of funds via bonds, shares, debentures, etc.

Hypothesis of the study:

The study will help analyze the steps to be taken in order to withstand and ensure stability in times of crisis in Bahrain banks.

Significance of the study:

The study is essential in the face of global crisis which had doomed many companies and moreover banks too. Bank in Bahrain too did not miss to be a target of this crisis. By the end of 2009 fiscal, the bank had been exposed to various challenges of crisis like drying up of credit, drastic fall in its corporate earnings and moreover failure to lure investors out of their market owing to price volatility after the dollar depreciation. The bank however worked on its strategies for crisis like focusing on matching its liabilities to maturity profile of assets thereby protecting their balance sheets. The bank moreover started supporting the financing needs of the portfolio owing to banks pulling out from the system.

Major factors that act as an immunity in times of crisis include proper governance, timely action to identify defaulters and effective tactics to identify genuine investors. The strategies used by banks in their core areas to fight crisis gives an idea as to how to tackle the crisis challenges.

In 2009, the financial sector sustains to be the major contributor to Bahrain's economy, accounting for 25.1% of real GDP. The total assets of retail banks stood at BD 22.5 billion as at 31 of December of the same year. Total outstanding credit facilities enlarged by retail banks to the diverse sectors of the domestic economy continued to be stable and amounted to BD 5,884.9m at end-2009, compared to BD 5,887.6 million at end-2008.

Even without the financial crisis, the real estate and construction sector remained embarked on and persisted many projects with a total of 9,928 construction permits issued in the same year. Several real estate projects continued to grow in 2009 Diyar Al Muharraq, Amwaj Islands and Durrat Al Bahrain.

The root for all these success in handling the crisis can be attributed to the carefully cultivated corporate culture that supports teams to work with quality, dedication, innovative thinking and coordinated decision-making. This has helped the bank to develop and maintain a conservative capital thereby helping mitigating risks.

Scope and limitations:

A major part of the study was based on the strategies to be undertaken in the wake of economic crisis. The strategies used by few banks are also applicable to other banks. Moreover effective co-ordination among investors and employees help ensure stability in operations. The study also focuses on strategies focused by banks on each of its diverse business areas with the advantage of giving diverse investment options to customers.

Major limitation included considering only bank in Bahrain for the impact of global crisis on banks in Bahrain. Another limitation is the timing. The researcher has limited time to fulfill this research and deliver it to the course mentor to pass the requirement of the degree. Hence the researcher will try to get as much related data as possible.

2 Chapter

Literature Reviews

1. Indirection:

1.1 History of banking and its growth:

Kiyotaki and Moor (1997), and Bernanke, Gertler and Gilchrist (1999) introduce financial frictions into business cycle models. Thus, we had the models which help us understand the financial frictions on just non financial institutions. Later, Albuquerque and Hopenhaya (2004), Alvarez and Jermann (2000), Jerman and Quadrini (2011) and Miao and Wang ( 2011 a,b,c) introduced a model to introduce financial frictions into the banking sector in the form of endogenous borrowing constraints - or Islamic banking and financing.

According to John F. Dix (July, 2009), there is no debate that the current troubled economic conditions were in large part caused by taking unreasonable and undefined risks. The role of excessive risk and the consequences that behavior caused has likely resulted in management taking a new and perhaps leery view of undertaking "opportunities" that are at all risky. Following are some thoughts concerning approaches to risk taking that allows risks to be taken with the assurance that the consequences are not fatal to the company and that an atmosphere of reasonable risk taking is indeed encouraged among the managers of the company. When these two conditions are imbedded in the culture of the company then risk taking becomes a powerful tool for growth and leadership.

Therefore in our model household put deposits in a bank and deposits become liabilities of the bank. Now if the bank chooses to default, then the depositors can seize a fraction of bank capital. Instead of liquidating seized bank capital, deposit repayments. The threat value to depositors is the stock market value of the bank with seized bank capital.

1.2 Background of the financial crisis:

The existing financial crisis faced by the banks is proving a challenge to the macroeconomists. Actually the traditional macroeconomists believed in the perfect market situation and did not recognize the financial frictions as observed in the last decade. Therefore the traditional models are not so helpful in understanding the present day financial crisis which has resulted in the fall of great economies of the world, especially the European countries. The fall of the global banks like Lehman brothers, Franklin Templeton and Barclay, followed by the fall of economies of Greece, Portugal, Cyprus, Spain Slovenia, Italy, Ireland, Slovakia, Malta, Belgium and now France, Austria and Germany joining the show.

1.3 How the financial crisis affected the banks performance:

As in Kocherlakota (2009), and Miao and Wang (2011a), we construct a third type of equilibrium in which households believe that banking bubbles may burst in the future with some probability. We show that even though there is no shock to the fundamentals of the economy, changes in confidence trigger a financial crisis. We show that immediately following the collapse of the banking bubble, deposit shrink, lending falls and credit spreads rise, causing real investment and output to fall.

Following Gertler and Karadi (2011) and Gertler and Kiyotaki (2010), we model this inefficiency as a deadweight loss of output. We also follow their studies and assume that the size of direct lending responds to credit spreads according to a feedback rule. In our model, credit spreads rise sharply at the onset of a crisis. The central bank then injects credit in response to movements in credit spreads, according to the feedback rule. We show that this credit policy can mitigate economic downturns. The net effect on welfare trades between this benefit and efficiency costs.

1.4 Effects of the financial crisis on Bahrain:

Bahrain is a small island-kingdom in the Middle East. Beside the oil and gas sector, the financial services sector is among the highest contributors to the country's overall GDP. According to the Central Bank of Bahrain's (CBB) annual report 2011, the sector contributed 25% to GDP of the country in 2010. Up to June 2011, the number of financial institutions in the country is 411 and the total financial sector workforce is 14,137. The banking system in the Kingdom of Bahrain is considered as being the largest component of the financial system. Bahrain's banking sector has remained to be a cornerstone for growth of the domestic economy. The banking sector represents over 85% of total financial assets (El-Quqa et.al, 2007).

Furthermore, the banking system compromises both Conventional and Islamic banks. The Conventional sector includes retails banks, specialized banks, wholesale banks and representative offices of overseas banks. On the other hand, the Islamic sector consists of retail banks and wholesale banks which offer as host of Sharia compliant products and services. The sole regulator for financial system in Bahrain is the CBB.

Up to December 2010, there are 6 Islamic retail banks and 18 Islamic wholesale banks operating in the kingdom (Hidayat, 2010). The high numbers of Islamic banks shows high profile of the country as the leading Islamic financial center in the region. In 2011, Islamic banks accounted for around 12% of Bahrain's banking sector (Winton, 2011)

1.5 Financial performance of Banks:

Bank capital requirements ensure that banks are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honoring deposit withdrawals. In our model, there is no uncertainty about fundaments and hence there is no issue of risk-taking behavior. However, it should be kept in mind that the bank is an Islamic bank, and in Islamic financing the real-estates are vital investment instruments which underlay an inherent

Shin (2012) and Bruno and Shin (2012) focus on the role played by large European banks. These banks are not only systemically important. These studies allude to three factors that fueled a lending boom accompanied by greater risk taking. The factors are

easy monetary policy that lowers funding costs for banks,

adoption of a regulatory structure that allows higher leverage, and

an asset price boom and real appreciation of the currency that strengthens the balance sheet position of borrowers.

Evidence for this for funding is provided by Baba, McCauley, and Ramaswamy (2009), who find that by mid-2008, justbefore the collapse of Lehman Brothers, over 40 percent of the assets of U.S. prime money market funds were short-term obligations of foreign banks, with obligations of global European banks representing the largest share.

Pornrojnangkool (2009), Hellman, Lindsey and Puri (2008), and Uchida, Udell and Yamori (2008)], and the borrower's choice of debt and lenders [e.g. Kwan and Carleton (2009)], there are relatively few studies on the effects of the lenders financial conditions on loan pricing.

Berger and Udell (2004) used the same kind of data as in this paper to link portfolio performance to the tightening of bank credit standards and lending volumes, referring to their findings as the institutional memory hypothesis.

Murfin (2009) studied the supply-side effects on loan covenants and found evidence that banks wrote tighter loan contracts than their peers after suffering defaults to their own portfolios, even when defaulting borrowers were in different industries and geographic regions than current borrowers.

For modern crises, the practical problem is that understanding crises by outsiders relies on observed events such as firm failures or government actions, and government statistics. This problem is manifest in defining and dating crises.

In the modern era the determination of whether an event is a crisis and when it starts and ends, is based on governments' actions because these are readily observable. Boyd, De Nicolò and Loukoianova (2011) study the four leading classifications and dating of modern crisis events.A They show that for many crises the dating of the start and end dates differ quite significantly.A There is also some disagreement on which events are crises.

Further, they show that the start dates are late.A This is because the government actions follow the crisis which has already begun, often in the form of a quiet run (Gorton (2012). The dating of the start and the end of a crisis is largely based on contemporary accounts of the crisis, and there is ambiguity

2. Financial performance of Banks:

2.1 How they measured performance:

Bank capital requirements ensure that banks are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honoring deposit withdrawals. In our model, there is no uncertainty about fundaments and hence there is no issue of risk-taking behavior. However, it should be kept in mind that the bank is an Islamic bank, and in Islamic financing the real-estates are vital investment instruments which underlay an inherent

Shin (2012) and Bruno and Shin (2012) focus on the role played by large European banks. These banks are not only systemically important. These studies allude to three factors that fueled a lending boom accompanied by greater risk taking. The factors are

easy monetary policy that lowers funding costs for banks,

adoption of a regulatory structure that allows higher leverage, and

an asset price boom and real appreciation of the currency that strengthens the balance sheet position of borrowers.

Evidence for this for funding is provided by Baba, McCauley, and Ramaswamy (2009), who found that by mid-2008,justbefore the collapse of Lehman Brothers, over 40 percent of the assets of U.S. prime money market funds were short-term obligations of foreign banks, with obligations of global European banks representing the largest share.

Pornrojnangkool (2009), Hellman, Lindsey and Puri (2008), and Uchida, Udell and Yamori (2008)], and the borrower's choice of debt and lenders [e.g. Kwan and Carleton (2009)], there are relatively few studies on the effects of the lenders financial conditions on loan pricing.

Berger and Udell (2004) used the same kind of data as in this paper to link portfolio performance to the tightening of bank credit standards and lending volumes, referring to their findings as the institutional memory hypothesis.

Murfin (2009) studied the supply-side effects on loan covenants and found evidence that banks wrote tighter loan contracts than their peers after suffering defaults to their own portfolios, even when defaulting borrowers were in different industries and geographic regions than current borrowers.

For modern crises, the practical problem is that understanding crises by outsiders relies on observed events such as firm failures or government actions, and government statistics. This problem is manifest in defining and dating crises.

In the modern era the determination of whether an event is a crisis and when it starts and ends, is based on governments' actions because these are readily observable. Boyd, De Nicolò and Loukoianova (2011) study the four leading classifications and dating of modern crisis events.A They show that for many crises the dating of the start and end dates differ quite significantly.A There is also some disagreement on which events are crises.

Further, they show that the start dates are late.A This is because the government actions follow the crisis which has already begun, often in the form of a quiet run (Gorton (2012). The dating of the start and the end of a crisis is largely based on contemporary accounts of the crisis, and there is ambiguity

3. Impact of financial crisis on bank performance:

The central irony of the governance failures of 2007-2008 was that many took place in some of the most sophisticated banks operating in some of the most developed governance environments in the world. A number of countries in different continent faced debt crisis. The examples of failures of major financial institutions in different continents and countries include the followings.

Europe

United Kingdom:

United States:

The major reasons that were concluded as the cause of such failure and crisis are categorized as follows.

Risk Governance.

Incapability of many boards to posess a comprehensive understanding.

Senior management failure to adopt the necessary part in the report.

Risk management is done in a visible manner.

Remuneration and alignment of incentive structures.

A good governance practice requires the alignment of executives and board renumeration with the long term interest of the company. This will decrease skepticism of the companies over incentive system and compensation.

Broad independence, qualifications, and composition.

Ensuring broad terms objectives with goal of preserving a balance of power will certainly help in productive tension among the board of directors. Thus after decreasing in productive tension, the ability to react the rising risk increases.

Shareholder engagement.

The right to appoint directors and to make key corporate decisions inform their decision making and prevent management from taking such decisions.

3. Studies and discussions:

3.1 Related Studies

Kassim and Majid, (2010) conduct a study aimed to arrive at empirical evidences on the impact of financial shocks (the 1997 and the 2007 financial crises) on the Islamic banks vis-a-vis the conventional banks in Malaysia. The study finds mixed evidences on the impact of the macroeconomic shocks on the Islamic and conventional banks. While the results based on the descriptive statistics indicate that the Islamic banks are relatively resilient to the financial shocks, the results based on the more robust econometric analysis reveal otherwise. The results based on the IRF analysis show that the Islamic financing responded significantly to macroeconomic shocks in non-crisis and 2007 crisis periods. The VDA results suggest that both Islamic and conventional banks are vulnerable to financial shocks.

Hassan and Dridi (2010) compare the performance of Islamic banks (IBs) and conventional banks (CBs) during the recent global crisis by looking at the impact of the crisis on profitability, credit and asset growth, and external ratings in a group of countries where the two types of banks have significant market share. The study suggests that IBs have been affected differently than CBs. Factors related to IBs'business model helped limit the adverse impact on profitability in 2008, while weaknesses in risk management practices in some IBs led to a larger decline in profitability in 2009 compared to CBs. IBs' credit and asset growth performed better than did that of CBs in 2008-09, contributing to financial and economic stability. External rating agencies'-assessment risk was generally more favorable.A 

Beck et al (2010) compare the performance of conventional and Islamic banks during the recent global crisis by looking at the impact of the crisis on business orientation, efficiency, asset quality, and stability in countries with data on at least four banks. The study suggests that Islamic banks seem more cost-effective than conventional banks in a broad cross-country sample. On the other hand, conventional banks seem more cost-effective than Islamic banks in a sample of countries with both Islamic and conventional banks. However, conventional banks that operate in countries with a higher market share of Islamic banks are more cost-effective but less stable. There is also consistent evidence of higher capitalization of Islamic banks and this capital cushion plus higher liquidity reserves explain the relatively better performance of Islamic banks during the recent crisis.

Haron (2004) found that expenditures (expenses) and profitability measures have a positive relationship. The study also suggests that size of the Islamic banks only had a significant positive relationship with one of performance indicators but was not significant with other profitability measures.

Burhonov (2006) found unclear relationship between short-term funding to the profitability indicators. The regression results also show that the impact of macroeconomic variables, GDP per capita on the profitability measures is not conclusive.

Alkassim (2007) finds that ROA for Islamic banks in GCC has positive coefficients with total assets and total expenses. Zantioti (2009) found that equity/total assets and GDP per capita statistically give positive significant impacts on Islamic bank profitability.

Thus the three important authors and their works and views can be shown in the following table.

Name of Author

Measurement of Performance

Findings

Results

Kassim and Majid, (2010)

Conduct a study aimed to arrive at empirical evidences on the impact of financial shocks (the 1997 and the 2007 financial crises) on the Islamic banks vis-a-vis the conventional banks in Malaysia.

The study finds mixed evidences on the impact of the macroeconomic shocks on the Islamic and conventional banks

The results based on the IRF analysis show that the Islamic financing responded significantly to macroeconomic shocks in non-crisis and 2007 crisis periods. The VDA results suggest that both Islamic and conventional banks are vulnerable to financial shocks.

Hassan and Dridi (2010)

Compared the performance of Islamic banks (IBs) and conventional banks (CBs) during the recent global crisis by looking at the impact of the crisis on profitability, credit and asset growth, and external ratings in a group of countries where the two types of banks have significant market share.

The study suggests that IBs have been affected differently than CBs.

Factors related to IBs'business model helped limit the adverse impact on profitability in 2008, while weaknesses in risk management practices in some IBs led to a larger decline in profitability in 2009 compared to CBs. IBs' credit and asset growth performed better than did that of CBs in 2008-09, contributing to financial and economic stability.

Beck et al (2010)

Compare the performance of conventional and Islamic banks during the recent global crisis by looking at the impact of the crisis on business orientation, efficiency, asset quality, and stability in countries with data on at least four banks.

The study suggests that IBs have been affected differently than CBs.

Factors related to IBs'business model helped limit the adverse impact on profitability in 2008, while weaknesses in risk management practices in some IBs led to a larger decline in profitability in 2009 compared to CBs. IBs' credit and asset growth performed better than did that of CBs in 2008-09, contributing to financial and economic stability. External rating agencies'-assessment risk was generally more favorable.

3.2 Discussion:

Creating Responsible Financial Markets

The steps to control such as situation were taken as follows.

Interventions made by state owned financial institutions.

Disclosure and transparency.

Redefining shareholders rights and responsibilities.

Other suggestions given by the experts to avoid such a situation in future include the followings.

The requirement of accountable capitalism.

Adding vertical regulations.

Considering new approach to regulations.

Formation of IOSCO (Global organization of securities.)

Thus a formal strategy has been planned which includes taking the following steps.

No single strategy.

Identifying business characteristics and performance from time to time.

Looking for cost efficiencies.

Creating suitable business size.

Keeping an eye on the throughput and prices.

Upgrading current business strategies.

Identifying the role of government in normal conditions.

The ICGN agenda: core issues to address

The crisis has highlighted a number of issues which are relevant to shareholders, particularly institutional shareholders, and these are areas where the ICGN will seek to engage actively in the policy debate. Below is a list of these issues and the ICGN's position on them.

Strengthening shareholder rights

Strengthening boards

Promoting fair and transparent markets

Independent accounting standards

Remuneration setting

Regulating credit rating agencies

The corporate governance also has a vital role in overcoming the financial crisis as seen in the last decade. Restoring confidence for the future and preventing regulations will help overcome the needs of the investors and ascertain economic growth in future.

This also consists of securing and maintains the rights of the shareholders and other kinds of transparency that helps in keeping a record of healthy financial position of the company, its upcoming goals and capacity to achieve them.

Also the shareholders must recognize the share owner's rights and responsibilities in the terms of creating a long term wealth for the shareholders and owners of the company.

Conclusion:

The current financial crisis has differently affected the economies of the various countries. While the capitalist and developed nations faced the financial crisis more severly. While the developing nation under control of the government governance showed lesser affect of the financial crisis.

Thus it's a good idea to allow the government to work as controlling agent like in China, India and other Asian countries wherein the governments were consistently and confidently trying their best to keep their economies on the right track. The final outcome is that all these countries especially the two mentioned were able to show consistent growth in the last decade while the rest of the world was facing financial crisis.

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